By now most of us realize that comments about QE2 do not refer to an ocean liner but to a policy articulated by the Federal Reserve Board (the Fed). The initials stand for Quantitative Easing, a technique for controlling the money supply. The appended number indicates that this is the second round of this policy's implementation. (The first round started in 2009 and lasted until March of this year with the Fed pumping $1.7 trillion of new money into our banking system.) The purpose and mechanics of QE2 are important to understand before venturing to assess the possible outcome.
The Fed has determined that our economic recovery is not robust enough, and that lending has to increase. Since short-term interest rates have fallen to near zero, regulatory attention has shifted to the longer term. Recently, interest rates on 30-year Treasury bonds hovered around 4 percent. To accommodate the attention shift the Fed has constructed a policy designed to lower long-term Treasury yields, encourage banks to lend more money, and push investors into riskier securities such as equities and high-yield bonds. One ancillary to this policy is to raise the target for inflation from 2 percent annually to 4 percent. (Inflation is now running at less than 1 percent annually.) The policy would also hope to depreciate the U.S. dollar against the currencies of our major trading partners, thus making imports more expensive for domestic consumers and exports more attractive to foreign buyers.
The Fed can implement this policy because it has the statutory authority to require its member banks to either buy or sell Treasury securities in designated amounts and maturities. If banks buy Treasuries, cash goes out of the banking system into the Fed's coffers, thereby reducing the supply of money. If banks sell Treasuries to the Fed, cash flows into the banking system while the central bank's securities holdings rise. (These holdings will exceed $2,5 trillion by the end of QE2.) Cash will add to the member banks' excess reserves, now estimated to be about $1 trillion.
As designed QE2 will involve the purchase of $600 billion of five- to eight-year Treasury debt from banks over eight months. These purchases will be financed by the printing of new money. The Fed also will use the proceeds from the sale of some mortgage-related holdings to buy medium- and long-term Treasuries from member banks. These purchases will amount to $250 billion to $300 billion, bringing the QE2 total to $850 billion to $900 billion.
An additional mechanism will affect this program. When bond price rise, yields fall; and if yields increase. prices fall. Should inflation increase as QE2 intends, holders of bonds, including the Fed, will see the value of their investments plummet. If QE2 does encourage investors to sell Treasuries in order to buy equities and lower-quality bonds, an asset bubble of some magnitude will be the likely result.
The Fed's intention is to encourage banks to lend more of their excess cash (instead of trading in financial markets or sitting on it) to further economic growth. The Fed also hopes the wealth created by asset appreciation will be spent to increase economic activity. (For example, if the $7 trillion in equities held by Americans rise 10 percent and all of the increase is spent, a bit less than one-quarter of 1 percent would be added to annual economic growth.) The Fed's aspirations constitute the best-case scenario. There are other possibilities.
Inflation, abetted by printing money, might prove hard to control. The modest objectives of the policy could have only a minimal impact upon the economy. A 1970s style stagflation could easily be the result. More lending on top of a nationwide debt load that is three times our yearly economic output (which is about $15 trillion) would make our country's balance even more precarious than it already is. Asset bubbles, as we recently learned, are prone to burst, causing widespread pain. Deliberately depreciating the dollar has already produced rumbles of currency war, may not affect imports or exports significantly, and will surely raise domestic prices.
The Fed has applied a short-term Band-aid to a serious long-term economic wound. Growth will not resume with any consistency until debt and deficits are reduced significantly (to around 60 percent of economic output for federal debt from 90 percent, to less two times output for total debt, and to less than 5 percent of annual output for the budget deficit from 9 percent). De-leveraging to produce a more solid national financial foundation takes time. The Fed has interrupted this necessary process with a risky policy with minimal shor- term upside that threatens the eventual return of fiscal responsibility.
The good ship QE2 has been launched. Whether the log of its voyage makes pleasant reading or resembles that of the Titanic remains to be seen. Watch carefully!